Interest rates keep going down and this provides great opportunities to do some pretty good tax planning. Let’s say, for the moment, that you want to make a loan to your children for a house, to start a business, or for something that requires an otherwise substantial loan. The IRS sets an interest rate called the Applicable Federal Rate (AFR), and if you use it, they will not intervene and try to impose a higher one.
It's a good time to take advantage of low interest rates. Photo courtesy of worradmu and FreeDigitalPhotos.net.
There are three levels of rates and they’re set every month. Now, get this, the rates set for October are the lowest ones since 1952, when the IRS started giving these AFR rates. Let’s go through these rates. Let’s say you have a short term loan, which is defined as a loan of three years or less. The interest rate for such a loan —if entered to in October 2011— is 0.16%. You claim that as income and the IRS will not bother you. For a three to nine-year loan, which is called a mid-term loan, the rate is 1.19%, and for loans over nine years, the rate is 2.93%.
This is an incredible opportunity for anybody who wants to make a loan to their children, for instance, at a very low rate. Now, someone would be tempted to do the short-term loan and keep rolling it over. This could be done but, unfortunately, the interest rate will most likely have changed at the end of the first term and it could be higher, so what you want to do is lock the rate that’s most appropriate for the length of the loan.
What has brought about this change? It’s all based on a number of indices the government uses to determine the AFR. I think it’s an excellent opportunity to look into succession planning and family planning.
Now let’s say you want to transfer stock to your children and the company is appreciating significantly, but you don’t want to eat into your exemption. You may remember, you have $13,000 per doni per year you can make, and we have this year —and we hope also next year, depending on what happens in Congress— a $5M exemption curb.
Now, let’s say you don’t want to use those. You have another option this year, called a GRAT, which stands for grantor-retained annuity trust. In order to set one of these up for a child, you need to come up with an annuity. Let’s use a three-year annuity for this example. You would have to give yourself an annuity which is equal to the amount you put in plus 1.19%, which is the mid-term rate. Any amount of appreciation in excess of 1.19% goes to the children completely tax-free and without costing you any gift tax. In the right situation, this is really great.
Obviously, if you think about these lower rates from a savings perspective, it’s a downer. But you can use it to your advantage.
Now, your children may be able to deduct that money depending on what they used it for. In tax policy, there’s something called the Interest Tracing Rules. If the money’s used for a vacation, it’s personal interest and that’s not deductible. On the other hand, if the money’s used to put it into a business, that’s fully deductible. If the money’s used to buy a house and the house is secured with a mortgage, this would fall under mortgage interest, which is fully deductible.
Obviously, we don’t know if these deductions will be kept in place. Both Democrats and Republicans are re-reading Harry Truman’s presidential campaign from 1948, when he campaigned against the “do-nothing” Congress, when he ended up being reelected.
Anyway, both parties would like to pass some type of tax legislation just to show that they are at least trying to ameliorate some of the problems with the economy and to reduce the deficit at the same time. So I think there’s a pretty good chance that there will be some type of tax legislation soon. There’s a lot of inertia in Congress to do something before Thanksgiving.
Whatever ends up happening, talk to your CPA or tax advisor now if you want to take advantage of these opportunities.
